competitorsâ€™ products. It is a growing issue considering the
expanding global economy.
Supplier issues Companies are segmenting the manufacture and delivery of
products and services. Some companies want to control all
aspects of manufacture. As noted, trends in todayâ€™s economic
climate show that more companies are outsourcing parts of all
of the development cycle. Due diligence needs to include the
viability of the supplierâ€™s ability to deliver on time, on budget
and within the established quality parameters. If the supplier
declares bankruptcy there may be significant issues impacting
the completion of company products as well as the financial
impact of not receiving value for payments already made.
Tax issues Tax increases, tax decreases, taxing authorities all need to be
monitored. Due diligence needs to include the potential
liability of taxes due to a growing number of governments
requesting tax dollars. On the other side of this coin is the
potential for the impact of economic loss on the tax liability.
In some cases, the liability may be greatly reduced and/or turn
to a cash refund. In this event, due diligence needs to make sure
that this is an accurate calculation and then consider what to do
with the returned funds.

These topics are not the only categories of information that an appropriate
due diligence exercise will want to assess and analyse. However, they do
demonstrate the range of issues that should be addressed in order to fulfil the
purpose of due diligence. When establishing due diligence activities, it is
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essential that the risk assessments have to expand beyond the most basic levels.
This is true wherever the exercise is taking place (for an example of a simple
due diligence exercise see later on in this chapter).
From a 21st century perspective, when considering, for example, joint ven-
tures or mergers and acquisitions, the traditional due diligence methods account
for 10 to 25% of a complete due diligence process, especially in light of the fact
that approximately two-thirds of all mergers and acquisitions fail completely, or
fail to deliver the value expected. Further comment on the level of failure is
made below. For the present purpose it should be noted that not all failures are
due to the lack of data gathering and appropriate due diligence procedures. Quite
often, it is the process of due diligence that reveals appropriate information that
this merger is not a good deal for one or both parties in terms of their risk man-
agement, risk appetite and culture. For example, the cultural due diligence exer-
cise can assist toward more successful outcomes.

Management emphasis
With enormous emphasis placed on the short term by most firms, espe-
cially those in the public markets, a quick increase in price or earnings for
the stock market is in many cases the sole reason for an M&A transaction.
Easy revenue increases or cost reductions often make management the
hero, albeit almost always at the cost of the stakeholders in the long term.

Having regard to the purpose of due diligence, in most places traditional
business views are based on a historical perspective. Examples of this type of
view are:
What were the level of earnings?
What did the CEO do?
How were sales made in the last quarter?
More analysis of completed transactions.
Following this model, traditional due diligence looks at the past, not the future,
to assess what a company can accomplish from today forward. This analytical
method is often performed too quickly and with a too narrow focus on com-
pleted transactions that may not be an appropriate predictor of future behaviour,
as this book seeks to demonstrate. Clearly there are now other modern tools and
resources available that can support a more through analytical process.

The transactional process: the role of due diligence
In most jurisdictions the typical legal traditional due diligence process usually
looks at the target or candidate company, its financials, its products, its market
and its employees, usually in that order of priority. This may be set against the
Chapter 4 â€“ Background to key aspects of legal risk management 83

risk management approach of the organisation. The process begins with a legal
questionnaire and disclosure documents attested by the candidate, and is
coupled with a review, compilation, or audit of financial records. Generally, a
regulatory agency records search is performed. Most often various public
records are searched. Often, research is added in areas such as the industry
niche(s) of the candidate, and sometimes the media. Sometimes, additional
research is added by contacting various industry and government organisations.
In the course of this process the use of warranties and indemnities has
developed to facilitate the transaction. Although the vendor may provide war-
ranties that provide assurances on exposed areas, the purchaser should check
them in any event. The verification approach reduces the potential for conflict
because problems can then be identified at an early stage. It can happen, for
example, that the vendor is unaware of the problems or issues that emerge
through the due diligence process.
It is important to note that warranties and indemnities given by vendors
often are qualified in certain respects:

Generally they are subject to time limits and last for only a few years, by oper-
ation of law and contract;
Usually they are limited by amount, including a maximum liability under the
warranties and an aggregate level of claims;
The compensation can be incomplete either because of the inadmissibility of
the claim or the restrictive method of calculating the damages, as well as the
fact that sometimes it is difficult to evaluate the compensation accurately as in
the case of loss of brand reputation (which is discussed in detail in Chapter 9);
There is usually a de minimis limit in respect of individual claims;
Any claim will only be successful if it is conducted in accordance with the
requirements for the conduct of claims;
Claims can be disputed, thereby causing financial and resource loss;
Even in the absence of a defence it can be costly and time consuming â€“ as
well a distracting â€“ to claim; and
The terms of the warranties and indemnities can be difficult to enforce.

In the light of the above, in many jurisdictions the due diligence process
requires the vendor to disclose all relevant information. Such disclosure enables
the purchaser to evaluate the target or candidate properly and to negotiate from
the perspective of a more even playing field. Therefore the process of the legal
due diligence can be used to provide information on the legal affairs of the tar-
get. In this context the organisationâ€™s compliance and legal risk management is
relevant. Such information can, of course, assist in the decision whether or not
to go ahead with the transaction and can clarify:

The assumptions made by the purchaser or agreed with the vendor, for
instance the rate of cancellation of contracts by customers;
The valuation of the target;
The operational capability of the target; and
The identification of any adverse factors.
Part A â€“ Overview of Risk Management
84

Once the purchaser has such information the process enables options that
include:
Proceeding with the transaction as agreed;
Cancelling or â€˜walking awayâ€™ from the transaction;
Negotiating specific indemnities; or
Changing the terms of the transaction.
As indicated, an important benefit of the legal due diligence process is that the
information reveals how the target has been managed having regard to sustain-
able risk management. This is very relevant to the overall discussion in the
book. It can take account of the background to the target and candidate and its
objectives including its chosen structure in the form of a company, partnership
or owner/manager operation. It should be understood that whereas many due
diligence exercises involve very large transactions there are also many smaller
deals that attract the due diligence process and different organisational vehi-
cles (the alternatives available are considered in Chapter 6. While some of the
issues in the process are clearly more suited to the larger transaction, others are
equally applicable whatever its size. For example, late or inaccurate returns to
the authorities such as the Inland Revenue and corporate registries will reflect
upon the management of the business. They may also indicate financial diffi-
culties, such as in financial statements lodged late with the corporate registries.
Following the transaction the due diligence information can provide an invalu-
able tool in the ongoing management of the target.

Areas of legal risk management in the due diligence
process
Key topics generally covered in the course of the due diligence process have
been indicated above. Many competent due diligence professionals have begun
to use a more comprehensive due diligence process. They have established a
broad range of topics that have to be monitored and reviewed on a continuous
basis which can also be useful in the overall context of risk management and
corporate governance.
As can also be seen from the discussion in Chapter 11, 21st century tech-
nology is the tool that enables continuous or ongoing due diligence relevant to
sustainable risk management. These areas include but are not limited to the
following:

It should be noted that the traditional due diligence process is largely
driven from a legal perspective. The legal practitioner typically delivers numer-
ous documents with the goal of being as legally reliable as possible. The legal
professional specifically builds a careful legal paper trail, and gathers as much
detail as possible regarding the legal condition of the candidate firm. In this
regard legal risk management is of obvious relevance. With the benefit of tech-
nology the point should once again be made that the 21st century due diligence
should prove to be advantageous through ongoing information gathering that
keeps the business abreast of its status in terms of corporate governance.

Sample UK due diligence
In the UK the typical legal due diligence exercise will cover some or all of
the areas listed. As has been noted in this manual the selected checklists
can only exemplify some of the general concerns and provide the basic
concerns that should be amended to reflect the individual circumstances
of the transaction. Therefore, this list does not purport to be conclusive
and will require tailoring according to such factors as:
Whether the transaction is a share purchase or asset purchase;
*
The targetâ€™s industrial sector;
*
The geographic location of its activities; and
*
The size of the transaction.
*
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